How do arbitrage opportunities work in stock markets?

Arbitrage opportunities in stock markets arise when a security is priced differently in two markets or forms. Traders and funds exploit these price gaps to buy low in one market and sell high in another, locking in a near-risk-free profit. Arbitrage is widely used by mutual funds, especially arbitrage mutual funds, in volatile or inefficient markets.

1. What is Arbitrage in the Stock Market?

Arbitrage refers to the strategy of buying a stock or asset in one market at a lower price and simultaneously selling it in another market at a higher price. The difference between the two prices becomes the arbitrage profit. This happens because of inefficiencies in pricing between cash markets (spot markets) and derivatives markets (futures).

Key Characteristics:

• Low risk (as both buy and sell happen simultaneously)
• Relies on price inefficiencies
• Usually involves large volumes for noticeable gains
• Common in high-frequency or algorithmic trading

2. How Arbitrage Opportunities Are Identified

Arbitrageurs use technology and data to track discrepancies in real-time. Here's how it works:

a) Spot-Futures Arbitrage

If a stock trades at ₹100 in the cash market but ₹102 in the futures market, an arbitrageur will buy the stock at ₹100 and simultaneously sell the futures contract at ₹102. When both prices converge at expiry, the trader books a profit of ₹2 per share.

b) Cross-Exchange Arbitrage

If a stock is priced at ₹450 on NSE and ₹452 on BSE, traders can buy on NSE and sell on BSE, making a small profit per trade. These price differences usually last for a very short time.

c) Merger Arbitrage

In M&A situations, if company A is acquiring company B, analysts estimate the final merger price. If company B’s stock is trading below that value, investors may buy it, expecting the price to move up post-merger approval.

3. Role of Arbitrage Mutual Funds

Mutual funds that use arbitrage as their core strategy are called arbitrage mutual funds. They buy stocks in the cash market and sell equivalent futures in the derivatives market.

Benefits for Investors:

• Low volatility compared to equity funds
• Taxed like equity funds (if held for over 1 year)
• Ideal for short- to medium-term parking of money
• Returns are slightly better than liquid or overnight funds in volatile times

These funds thrive during high market volatility, as the price differences between spot and futures widen.

4. What Makes Arbitrage Opportunities Disappear?

As more traders spot an arbitrage opportunity, their actions bring prices in line and eliminate the gap. For example, if many traders start buying in one market and selling in another, demand rises in one and supply increases in the other, removing the price difference quickly.

Factors That Reduce Arbitrage Gaps:

• High-frequency trading
• Increased market efficiency
• Transaction costs eating into profits
• Regulatory restrictions on simultaneous trades

5. Is Arbitrage Risk-Free?

While arbitrage is considered low risk, it is not entirely risk-free. Some common risks include:

• Execution risk: Price differences may disappear before both trades are completed.
• Liquidity risk: One of the markets may lack sufficient volume to execute the trade.
• Regulatory risk: New rules could affect arbitrage strategies.

That's why arbitrage is best left to professionals or through mutual funds that manage these strategies efficiently.

Arbitrage opportunities allow investors and funds to profit from price differences across markets. Though the profits per trade may be small, with the right volume, timing, and strategy, these opportunities can lead to consistent gains. Arbitrage mutual funds are a smart way for retail investors to benefit from this low-risk strategy without the hassle of active trading. In volatile markets, arbitrage becomes even more effective — offering returns with minimal equity-like risk. Use platforms like Angel One to explore arbitrage investments easily.